What is working capital funding?
Working capital funding, also known as working capital financing, is a method of business financing designed to increase working capital. It’s typically used to fuel immediate business growth or cover short-term costs, as opposed to other types of business financing, which have a longer timeline.
Working capital, defined as current assets minus current liabilities, is a fundamental resource for every business. It’s used to meet short-term financial obligations, maintain a steady flow of production, and generally keep operations running smoothly. It also doubles up as a financial health indicator, representing a business’s short-term liquidity.
Companies that find themselves in a poor working capital position, including having a net-negative working capital balance, can struggle to survive. This is particularly threatening to new businesses with low cash inflows and high initial outflows. Without immediately available capital, they may be unable to invest in inventory, service debt, or even pay employees.
Working capital funding can support these businesses, acting as a financial bridge that helps them to continue operating without having to take on more expensive long-term debt.
Types of working capital funding
There are many different types of working capital funding to choose from. Each one provides a short-term working capital position improvement but has its own unique pros and cons. These are some of the most common:
Working capital loans
Working capital loans, sometimes called bridging loans or short-term loans, are like typical business loans but typically feature a short- or medium-term repayment plan. They are designed to help businesses bridge the gap between cash inflows.
There are two main types of working capital loans: secured and unsecured. Secured working capital loans require assets to use as collateral, so the amount you can borrow is limited by the value of your business’s assets. The more common unsecured working capital loans don’t require collateral, but your lending ability will be limited by a credit score assessment.
Invoice financing is a working capital funding method where businesses borrow money using their outstanding customer invoices as collateral. It’s a form of accounts receivable financing.
It allows companies to access immediate cash by borrowing against the value of their unpaid invoices, essentially taking out a business line of credit backed by outstanding debt due to be received by customers. This means they’re no longer limited by the payment terms and can benefit from their inflows much quicker, expediting cash flow.
Businesses that choose invoice financing are still responsible for managing the collections process and so don’t have to disclose the financing arrangement to customers. Once the invoices are paid, the borrower then closes the invoice financing deal by repaying the money that was borrowed from the financer.
Invoice factoring is similar to invoice financing and is another type of accounts receivable financing. It also involves raising money using unpaid customer invoices, meaning businesses can boost their working capital position in the immediate term using their accounts receivable. But, instead of borrowing against them as in an invoice financing agreement, they are sold in full to the financer (known as the factor).
That means that the factor is responsible for collecting invoice payments from customers before their due date. This frees up the borrower from the collections process, which can save them time and effort. However, it also means that invoice factoring agreements generally have to be disclosed to customers, so they expect the factor to get in touch.
Asset refinancing, also known as asset-based lending, is a strategic way for businesses to unlock capital tied up in their existing assets. This form of working capital funding involves using tangible assets, such as equipment, machinery, or real estate, as collateral to secure a loan. It’s essentially the same as a secured working capital loan.
By leveraging assets, businesses can access funds quickly to support their working capital needs. Asset refinancing is ideal for companies with valuable assets but limited cash flow, providing them with an opportunity to maintain operations, invest in growth, or address any short-term financial challenges they may encounter.
Why is working capital funding important?
Working capital funding can play a vital role in business success, ensuring seamless daily operations, sustained production, and the ability to meet short-term financial obligations.
In some cases, including for new businesses that have slow cash flow, it can act as a crucial financial lifeline. Without adequate working capital, businesses may face challenges covering their operational costs, including paying suppliers, maintaining inventory levels, and even covering payroll. This hinders their ability to thrive in a competitive market.
By securing working capital funding, businesses can bolster their financial health, enhance resilience, and capitalize on growth prospects. These are some of the top benefits of working capital funding:
Cover short-term costs
Working capital funding can be used to stay afloat in temporary situations of negative cash flow. A timely injection of cash from a working capital funding agreement can be used to buy more inventory, pay employees, or otherwise allow operations to continue.
Fuel business growth
Growth typically relies on increased funding, whether for R&D, new equipment, or geographic expansion. But this creates a Catch-22, where to fund the growth, you need to have the resources you’ll have after the growth. Working capital funding solves this, allowing companies to invest in their future with borrowed capital that they can repay when they’re benefitting from revenue growth
Helps supplier relationships
Working capital funding can help businesses to build better relationships with both their customers and suppliers. The former is achieved by minimizing the need to chase unpaid invoices aggressively, meaning customers can utilize the full length of their payment terms without pressure. The latter is possible by ensuring businesses can pay their suppliers in full and on time by using a working capital funding method when they don’t have the capital immediately available.
Working capital funding also offers businesses more flexibility than other business financing options. Alternatives, like long-term business loans or equity financing, can be costly – involving significant interest payments and loss of equity, respectively. While working capital funding often does involve a fee, it’s generally small compared to the alternatives.